8/17/2008 @ 11:00AM

The Roth 401(k): Tax Me Now

As the new kid in town, the Roth 401(k) is getting pretty popular. If your employer hasn’t already added him as a retirement savings option, it soon may.

With so many different retirement planning tools–401(k), IRA, Roth IRA–you investing geeks out there must be starting to feel like a kid in a candy store. The rest of you are probably just feeling really stressed out.

But don’t fret–as its name suggests, the Roth 401(k) is essentially a combination of the traditional 401(k) and the Roth IRA. For a quick refresher on the difference between the 401(k) and Roth IRA, check out “Splitting your Savings.”

Like a traditional 401(k), a Roth 401(k) is only offered through your employer. So if your employer does not offer a traditional 401(k) savings plan–or 403(b) plan for those of you in non-profits–you’ll have to stick with a traditional IRA or Roth IRA.

Like a Roth IRA, a Roth 401(k) is a retirement plan for after-tax dollars. You’re taxed on Roth 401(k) contributions as income before the money goes into the account. As long as you withdraw that money after at least five years and after age 59 and a half, you won’t pay taxes on distributions. The exceptions to early Roth 401(k) are similar to that of a traditional 401(k); “Start Savings With A 401(k)” highlights these exceptions.

One of the benefits of a Roth 401(k) over a Roth IRA is the amount you can invest annually. There are strict contribution limits with the Roth IRA: If you’re younger than 50, you can only contribute up to $5,000 annually, provided you don’t make too much money ($116,000 if you’re single and $169,000 if you’re married).

In a Roth 401(k), you have the same contribution limits as the traditional 401(k): $15,500 a year for 2008. Keep in mind the $15,500 is a combined contribution of both the 401(k) and Roth 401(k), but it’s still much more than you’re allowed with a Roth IRA. If you have the ability to invest more than you’re allowed into a Roth IRA, the Roth 401(k) would be ideal. Also, in some cases, your employer can choose to match your Roth 401(k) contributions.

The Roth IRA has one significant advantage over the Roth 401(k). Like a traditional 401(k), you must begin withdrawing distributions from your Roth 401(k) by age 70 and half to avoid penalties; you can keep Roth IRA money in your account for as long as you like. You can also roll your Roth 401(k) or 401(k) money into a Roth IRA. You cannot, however, do the reverse.

There is also the critical question over whether it’s wiser to invest pre-tax dollars in a traditional 401(k) or after-tax dollars in a Roth version. Ideally, you would invest according to which tax bracket you assume you’ll be in when you retire. Unfortunately, there is no real science to figuring out this one.

Most people assume that they’ll be making less money when they’re retired. But your investments may have done well and your income could be higher than it is today, even without you working (this is not a terrible problem to have, obviously).

The ultimate consideration is the tax rate you’ll be paying on withdrawals. If you had to speculate, it’s not difficult to believe that tax rates will be higher in the next 30 to 40 years than they are now. Effective federal tax rates have been coming down for the past three decades, and because of commitments to Social Security and Medicare, Uncle Sam should be looking for money anywhere and everywhere by 2040 or so.

Diversifying your retirement savings may be the best approach to take. Put whatever else you can afford into either a Roth IRA or Roth 401(k). Invest in the traditional 401(k) an amount at least equal to your potential employer match.

“We’re talking about 30 to 50 years before someone in their 20s will be considering retirement,” says J. Graydon Coghlan, a financial adviser in San Diego, Calif. “As we know, many things will change over such a long period of time.”